EDHEC Risk: Banking on Liquidity
07 July 2010
EDHEC Risk report explores the changes in the nature of banking activities over the past few decades which are fundamental to understand the failings that resulted in the financial crisis. The role and extent of liquidity and collateral security is fully analyzed and policy recommendations are made.
EDHEC Risk report explores the changes in the nature of banking activities over the past few decades which are fundamental to understand the failings that resulted in the financial crisis. The role and extent of liquidity and collateral security is fully analyzed and policy recommendations made.
Conclusions
The very simple model developed by Holmstrom & Tirole demonstrates that markets have limits and that reliance upon them alone for bank funding is flawed. EDHEC has considered trade-offs between transaction, or flow, liquidity and the liquidity stock. Much of market participant activity emphasises the former and ignores the latter. It also demonstrates that derivatives activity, even when fairly priced, can reduce the liquidity stock. The ICMA 2009 survey reports that more than $4 trillion of collateral was posted in support of derivatives contracts.
Liquidity has not figured on the international regulatory agenda until recently. In Basel II it was evident (though obscured may be more correct) only in that tier-two capital admitted debt securities with a term longer than five years—the term being related to liquidity demand.
EDHEC has documented material issues associated with the stock of liquidity for banks engaged in both risk management services and traditional loan and deposit banking. EDHEC has illustrated that the scale of these activities may impose significant pressures on both a bank’s and the system’s liquidity.
EDHEC has considered the role of collateral in this process. EDHEC believes that central counterparties, which are widely advocated in resolution of some of the perceived difficulties with derivatives, will not resolve these liquidity and related problems but rather will concentrate them. EDHEC has noted some consequences of derivatives of concern for financial markets—the induced path-dependency —as well as for the economy and for bank shareholders, in particular, weakened management due diligence incentives.
© EDHEC
